Barton Biggs On Why Markets Will Rally
I recently laid out in NEWSWEEK the bearish argument for why we should be very gloomy about the global economy, bearish about stock markets and deeply depressed about the world in general. I told readers it was my belief that there was a 50 percent chance that the world was facing a long cycle of recession, depression and wealth destruction. I maintained that the bears believe that the best-case economic scenario is Japan's agony since the 1990s, and the worst is a replay of the 1930s.
Since I wrote that piece, two things have happened. The first is that the global economic outlook has deteriorated—the market consensus now is that the angle of descent of the U.S. economy, as well as that of Europe and the major emerging markets, has steepened. Second, and even more disconcertingly, President Obama has announced what many investors consider to be a populist redistributionist tax agenda, which increases the tax rate on capital gains and dividends and gives tax reductions and distributions to the middle class and the poor. Neither event has buoyed investor mood.
Despite this, I still believe that there is a 50 percent probability of a happier outcome. The world is having the most severe recession of the postwar era, and the recovery will be sluggish and plagued by inflation. Nevertheless, the doomsday scenario of depression and deflation, with 5000 on the Dow Jones industrial average and 500 on the S&P 500, is farfetched. Markets could be on the brink of a major rally, and the U.S. economy may begin to recover later this year. Here are the reasons, in no particular order.
First, the financial panic and the collapse of the world economy caught the so-called Authorities (i.e., the central banks and the governments of the world) by surprise. They reacted slowly, but nevertheless far faster than the Authorities in the U.S. in the 1930s or Japan in the 1990s. In both those cases, the Authorities were not only tardy, but they also made serious policy errors, such as raising tax rates, imposing tariffs and not curing the banking systems. These mistakes are now well understood—the current Fed chairman has written a book on the subject.
This time around—and this is very important—the Authorities have unleashed powerful fiscal and monetary stimuli that are totally unprecedented in size and scope. Interest rates have been dramatically cut everywhere, and every week more countries announce new fiscal-stimulus programs. It takes time for these actions to affect economic activity. Rate cuts and expansion of the money supply are powerful medicine, but won't make a difference for at least a year. Fiscal programs are quicker, but also take time to implement. The actions of the Authorities should begin to boost activity by the late spring, and their uplifting effect will grow as the year progresses. In the United States, the fiscal-stimulus program is expected to add 4 percentage points to real GDP growth in both the second and third quarters of this year. In other words, the world economy should begin to level out and improve as time goes on. We are not in a hopeless death spiral, as the bears say.
Second, the bourses of the world have been falling since 2000 and, adjusted for inflation, are down 60 to 70 percent. The sorry state of the world economy is front-page news. Therefore, it stands to reason that the bad news is extremely well known and must be pretty thoroughly priced into the markets. Treasury bonds have vastly outperformed stocks for 10 years, and the relationship between the two is back to the level of the early 1980s, which was a fabulous buying opportunity for stocks; 1982 was the takeoff point for the greatest bull market in history. Bear in mind that for the entire 20th century, a turbulent 100 years, the annual real return for stocks in the U.S. was 6.9 percent, versus 1.8 percent for Treasury bonds. In Sweden the relevant figures were 8.2 percent per year versus 2.3 percent for bonds; in Germany, 3.7 percent versus minus 2.3 percent; and in Japan, 5 percent versus 1.6 percent. Why would you want to be a lender to the U.S. government rather than an owner of real assets or the means of production at a moment when the government is printing more paper than at any time in its history? Rolling more money off the printing presses always eventually means higher inflation and interest rates, which is, of course, bad for bonds.
Third, depending on your frame of reference, stocks are either cheap or very cheap, in absolute terms as well as versus inflation and interest rates. In America, the price-to-earnings ratio of the S&P 500 when it is calculated on a market-capitalization-weighted basis is about nine times already depressed earnings. At the height of the bubble in 2000 that ratio was close to 20 times, and at the peak of the recovery in the fall of 2007, it was around 15. In addition, the yield on stocks in both the U.S. and Europe is higher than that on government bonds. Over the long run, the ratio of a company's stock price to its book value (a measure of the retained earnings of a company) and the ratio of its stock price to sales have been the best predictors of performance, and they show exceptional value at the moment. Buy low, sell high!
Fourth, sentiment is just incredibly depressed. I have never seen anything like it, not even in 1974 when the outlook was very grim indeed. Back then, America had just lost a war in Vietnam and nearly impeached a president, it was suffering hyperinflation and a recession, and its cities were on fire. Still, the gloom wasn't at the levels that we are seeing today. Money-market cash is equivalent to 43 percent of the total capitalization of U.S. stocks, an all-time high. The return on cash is zero! Hedge funds hold more cash than ever before. Private-equity funds are literally being given away because their owners don't want the risk. All of it shows how bearish everyone is.
Over 40 years, my experience has been that when everyone is bearish and has acted accordingly, it is invariably right to be gradually buying. Being a contrarian works. The bottom of a stock-market cycle by definition has to be the point of maximum bearishness. The news doesn't have to be good for prices to rally; it just has to be less bad than what has already been factored into the market.
Already there are some glimmers of hope. In the oil-consuming countries, the huge drop in oil prices is similar to a massive tax cut. The fall in consumption is beginning to level out. Inventories have been reduced to levels so low that production will have to be increased even to meet the current depressed level of demand. The Japanese car companies have announced assembly-line increases, and in the U.S. auto dealers and home builders' surveys have looked up. Last week, the purchasing managers index (PMI) in China rose for the third consecutive month. JPMorgan's global manufacturing PMI posted a second consecutive gain in February, and its new-orders index has turned and is rising. These indexes are still in recession territory, but the rate of change, the so-called second derivative, has turned up. U.S. house prices are still falling, and mortgage foreclosures are rising. However, the affordability of housing has soared and existing home sales are rising. The Obama administration is proposing major mortgage-term restructuring.
The final antidote to despair was captured by Bernard Baruch in his 1932 foreword to a reprint of Charles Mackay's classic book "Extraordinary Popular Delusions and the Madness of Crowds." "If in the lamentable era of New Economics that preceded the crash of 1929, primitive investors had only chanted to themselves 'two plus two still equals four,' then the disaster might have been averted," wrote Baruch. Similarly, he said amid the gloom that had descended by 1932, "when many begin to wonder if declines would never halt, the appropriate abracadabra may be: 'They always did'." And they always will.
